Private corporations and income splitting

Private corporations and income Splitting

Income splitting is the process of redirecting income within a family group to take advantage of lower tax brackets, deductions, and credits available to each family member. Generally speaking, the total tax on family income will be the lowest when each member earns approximately the same amount of income.

Income splitting can transfer income that was previously taxed at the top rates into lower brackets, with more after-tax cash remaining within the family unit.

How to split income 

Very simply, income is split by transferring income-earning assets from high-income to lower-income family members. Besides the Tax on Split Income (“TOSI”) rules, which generally target income splitting through the payment of dividends on shares of private companies, there are several income attribution rules in the Income Tax Act (“ITA”). These attribution rules work to ensure that a transfer of income-earning property by gift or certain other transfers between spouses and to minor children will result in the attribution of income from such transferred assets back to the transferor.

Dividends after age 65

A notable exception to the TOSI rules occurs when an owner-manager or their spouse has reached age 65 by the end of the taxation year. Where that owner-manager has made a sufficient contribution to the family business to qualify for an exclusion under the TOSI rules, dividends that their spouse may receive on shares of the corporation will be exempt from TOSI.  If the spouse has shares of a different class from the owner, the spouse can generally receive dividends that will not contribute back to the owner-manager.

Prescribed rate loans

Arranging a prescribed rate loan between spouses can be a good way to create an income-splitting opportunity. If a business owner makes an investment loan to a spouse, adult family member, minor child or family trust and charges interest on the loan at the prescribed interest rate, then any income they earn on the funds will be taxable to the recipient family member, and not to the business owner.   

The recent rapid increase in interest rates has made creating a new prescriber rate loan more difficult since the interest rate on the loan to a family member must be at least equal to the government-prescribed rate at the time the loan is made.

Second generation income

The general income attribution rules in the ITA apply only to the first income that is generated on gifted or transferred assets. Keeping the initial investment capital in a separate account from the reinvested second-generation earnings is important to not co-mingle funds on which income is attributable back to the transferor with funds not subject to attribution.  

Salaries

The TOSI rules do not restrict the ability of a business owner to pay their family members, reasonable wages for work that they have done. The key element here is the amount of wages must be reasonable compared to what an arm’s length person, with the same level of experience, will be paid for the same work.

How can BDO help?

Planning to transfer income-producing assets within a family group can result in a lower overall family tax bill. However, it is not without risks, and it can be complicated to put an effective plan in place as it very much depends on your circumstances.

Scott Conner is an experienced tax practitioner and practical problem solver at BDO. As a partner specializing in Canadian income tax, Scott has particular specialties in private companies, planning for estates, trusts, and complex transactions. As personal tax season approaches, Scott and his team understand personal taxes are as individual as clients themselves. BDO works closely with their clients to understand their specific needs and adjust strategies accordingly. BDO partners and staff take a proactive, hands-on approach. They closely follow existing and proposed legislation to determine how it will affect individual financial goals, and provide ongoing guidance.